Capm PDF

FIN501 Asset Pricing
Lecture 06 Mean-Variance & CAPM (1)
Markus K. Brunnermeier
LECTURE 06:
MEAN-VARIANCE ANALYSIS & CAPM
Overview
1. Introduction:
Simple CAPM with quadratic utility functions
(from beta-state price equation)
2. Traditional Derivation of CAPM
– Demand: Portfolio Theory for given
– Aggregation: Fund Separation Theorem prices/returns
– Equilibrium: CAPM
3. Modern Derivation of CAPM
– Projections
– Pricing Kernel and Expectation Kernel
4. Testing CAPM
5. Practical Issues – Black-Litterman
Recall State-price Beta model

Recall:
𝐸 𝑅ℎ − 𝑅 𝑓 = 𝛽ℎ 𝐸 𝑅∗ − 𝑅 𝑓
cov 𝑅 ∗ ,𝑅 ℎ
Where 𝛽 ℎ ≔
var 𝑅∗
very general – but what is 𝑅 ∗ in reality?

Simple CAPM with Quadratic Expected Utility
1. All agents are identical

𝜕1 𝑢
• Expected utility 𝑈 𝑥0 , 𝑥1 = 𝑠 𝜋𝑠 𝑢 𝑥0 , 𝑥𝑠 ⇒ 𝑚 = 𝐸 𝜕0 𝑢
• Quadratic 𝑢 𝑥0 , 𝑥1 = 𝑣0 𝑥0 − 𝑥1 − 𝛼 2
• ⇒ 𝜕1 𝑢 = −2 𝑥1,1 − 𝛼 , … , −2 𝑥𝑆,1 − 𝛼
• Excess return
ℎ 𝑓 ℎ
cov 𝑚, 𝑅 𝑅 cov 𝜕1 𝑢, 𝑅
𝐸 𝑅ℎ − 𝑅𝑓 = − =−
𝐸𝑚 𝐸 𝜕0 𝑢
𝑓
𝑅 cov −2 𝑥1 − 𝛼 , 𝑅 ℎ 2cov 𝑥 , 𝑅 ℎ
1
=− = 𝑅𝑓
𝐸 𝜕0 𝑢 𝐸 𝜕0 𝑢
• Also holds for market portfolio
𝐸 𝑅ℎ − 𝑅 𝑓 cov 𝑥1 , 𝑅ℎ
=
𝐸𝑅 𝑚𝑘𝑡 −𝑅 𝑓 cov 𝑥1 , 𝑅𝑚𝑘𝑡
Simple CAPM with Quadratic Expected Utility
𝐸 𝑅ℎ − 𝑅 𝑓 cov 𝑥1 , 𝑅ℎ
=
𝐸 𝑅𝑚𝑘𝑡 − 𝑅 𝑓 cov 𝑥1 , 𝑅𝑚𝑘𝑡
2. Homogenous agents + Exchange economy

⇒ 𝑥1 = aggr. endowment and is perfectly correlated with 𝑅𝑚
𝐸 𝑅ℎ − 𝑅 𝑓 cov 𝑅𝑚𝑘𝑡 , 𝑅ℎ
=
𝐸 𝑅𝑚𝑘𝑡 − 𝑅 𝑓 var 𝑅𝑚𝑘𝑡
cov 𝑅ℎ,𝑅𝑚𝑘𝑡
ℎ
Since 𝛽 =
var 𝑅𝑚𝑘𝑡
Market Security Line
𝐸 𝑅ℎ = 𝑅 𝑓 + 𝛽ℎ 𝐸 𝑅𝑚𝑘𝑡 − 𝑅 𝑓
𝑎+𝑏1 𝑅 𝑚𝑘𝑡
NB: 𝑅 ∗ = 𝑅 𝑓 in this case 𝑏1 < 0 !
𝑎+𝑏1 𝑅 𝑓
Overview
1. Introduction:
– Projections
4. Testing CAPM
Definition: Mean-Variance Dominance

& Efficient Frontier
• Asset (portfolio) A mean-variance dominates
asset (portfolio) B if 𝜇𝐴 ≥ 𝜇𝐵 and 𝜎𝐴 < 𝜎𝐵 or
if 𝜇𝐴 > 𝜇𝐵 while 𝜎𝐴 ≤ 𝜎𝐵 .
• Efficient frontier: loci of all non-dominated
portfolios in the mean-standard deviation
space.
By definition, no (“rational”) mean-variance
investor would choose to hold a portfolio not
located on the efficient frontier.
Expected Portfolio Returns & Variance
• Expected returns (linear)

ℎ𝑗
– 𝜇ℎ ≔𝐸 𝑟ℎ = 𝒘ℎ ′𝝁, where each 𝑤𝑗 = 𝑗
𝑗ℎ
Everything is in returns
• Variance (like all prices =1)
– 𝜎ℎ2 ≔ var 𝑟ℎ = 𝒘′ 𝑉𝒘
𝜎12 𝜎12 𝑤1
= 𝑤1 𝑤2
𝜎21 𝜎22 𝑤2
= 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎12 ≥ 0
Illustration of 2 Asset Case

• For certain weights: 𝑤1 and 1 − 𝑤1
𝜇ℎ = 𝑤1 𝜇1 + 1 − 𝑤1 𝜇2
𝜎ℎ2 = 𝑤12 𝜎12 + 1 − 𝑤1 2 𝜎22 + 2𝑤1 1 − 𝑤1 𝜌12 𝜎1 𝜎2
(Specify 𝜎ℎ2 and one gets weights and 𝜇ℎ ’s)
• Special cases [𝑤1 to obtain certain 𝜎ℎ ]

±𝜎ℎ −𝜎2
– 𝜌12 = 1 ⇒ 𝑤1 =
𝜎1 −𝜎2
±𝜎ℎ +𝜎2
– 𝜌12 = −1 ⇒ 𝑤1 =
𝜎1 +𝜎2
±𝜎ℎ −𝜎2
For 𝜌12 = 1 ⇒ 𝑤1 =
𝜎1 −𝜎2
𝜎ℎ = 𝑤1 𝜎1 + 1 − 𝑤1 𝜎2
𝜇2 − 𝜇1
𝜇ℎ = 𝑤1 𝜇1 + 1 − 𝑤1 𝜇2 = 𝜇1 + ±𝜎ℎ − 𝜎1
𝜎2 − 𝜎1
𝜇2
𝜇ℎ
𝜇1
𝜎1 𝜎ℎ 𝜎2 Lower part is irrelevant
𝜇2 − 𝜇1
𝜇ℎ = 𝜇1 + −𝜎ℎ − 𝜎1
𝜎2 − 𝜎1
The Efficient Frontier: Two Perfectly Correlated Risky Assets

±𝜎𝑝 +−𝜎2
For 𝜌12 = −1 ⇒ 𝑤1 =
𝜎1 +𝜎2
𝜎ℎ = 𝑤1 𝜎1 − 1 − 𝑤1 𝜎2
𝜎2 𝜎1 𝜇2 − 𝜇1
𝜇ℎ = 𝑤1 𝜇1 + 1 − 𝑤1 𝜇2 = 𝜇 + 𝜇 ± 𝜎
𝜎1 + 𝜎2 1 𝜎1 + 𝜎2 2 𝜎1 + 𝜎2 𝑝
𝜇2 𝜇 −𝜇
slope: 𝜎2 +𝜎1
1 2
𝜎2 𝜎
intercept: 𝜇 + 1 𝜇
𝜎1 +𝜎2 1 𝜎1 +𝜎2 2 𝜇 −𝜇
slope: − 𝜎2+𝜎1
𝜇1 1 2
𝜎1 𝜎2
The Efficient Frontier: Two Perfectly Negative Correlated Risky Assets

For 𝜌12 ∈ −1,1
E[r2]
E[r1]
s1 s2
The Efficient Frontier: Two Imperfectly Correlated Risky Assets

For 𝜎1 = 0
𝜇2
𝜇ℎ
𝜇1
𝜎1 𝜎ℎ 𝜎2
The Efficient Frontier: One Risky and One Risk-Free Asset

Efficient frontier with n risky assets

• A frontier portfolio is one which displays minimum variance
among all feasible portfolios with the same expected
portfolio return.
𝔼[𝑟]
1
• min 𝒘′ 𝑉𝒘
𝒘 2
– 𝜆: 𝒘′ 𝝁 = 𝜇ℎ , 𝑗 𝑤𝑗 𝔼 𝑟𝑖 = 𝜇ℎ
– 𝛾: 𝒘′ 𝟏 = 1, 𝑗 𝑤𝑗 =1
s
• Result: Portfolio weights are linear in expected portfolio return
𝑤ℎ = 𝓰 + 𝓱𝜇ℎ
– If 𝜇ℎ = 0, 𝑤ℎ = 𝓰
– If 𝜇ℎ = 1, 𝑤ℎ = 𝓰 + 𝓱
• Hence, 𝓰 and 𝓰 + 𝓱 are portfolios on the frontier
𝜕ℒ
= 𝑉𝒘 − 𝜆𝝁 − 𝛾𝟏 = 0
𝜕𝑤
𝜕ℒ
= 𝜇ℎ − 𝒘′ 𝝁 = 0
𝜕𝜆
𝜕ℒ
= 1 − 𝒘′ 𝟏 = 0
𝜕𝛾
The first FOC can be written as:

𝑉𝒘 = 𝜆𝝁 + 𝛾𝟏
𝒘 = 𝜆𝑉 −1 𝝁 + 𝛾𝑉 −1 𝟏
𝝁′ 𝒘 = 𝜆 𝝁′ 𝑉 −1 𝝁 + 𝛾 𝝁′ 𝑉 −1 𝟏 skip
• Noting that 𝝁′ 𝒘ℎ = 𝑤ℎ′ , combining 1st and 2nd FOC

𝜇ℎ = 𝝁′ 𝒘ℎ = 𝜆 𝝁′ 𝑉 −1 𝝁 + 𝛾 𝝁′ 𝑉 −1 𝟏
𝐵 𝐴
• Pre-multiplying the 1st FOC by 1 yields

𝟏′ 𝒘ℎ = 𝒘′ℎ 𝟏 = 𝜆(𝟏′ 𝑉 −1 𝝁 + 𝛾 𝟏′ 𝑉 −1 𝟏 = 1
1 = 𝜆(𝟏′ 𝑉 −1 𝝁)+ 𝛾 𝟏′ 𝑉 −1 𝟏
𝐴 𝐶
• Solving for 𝜆, 𝛾
𝐶𝜇ℎ − 𝐴 𝐵 − 𝐴𝜇ℎ
𝜆= , 𝛾=
𝐷 𝐷
𝐷 = 𝐵𝐶 − 𝐴2
skip
• Hence, 𝒘ℎ = 𝜆𝑉 −1 𝝁 + 𝛾𝑉 −1 𝟏 becomes
𝐶𝜇ℎ − 𝐴 −1 𝐵 − 𝐴𝜇ℎ −1
𝒘ℎ = 𝑉 𝝁+ 𝑉 𝟏
𝐷 𝐷
1 1
= 𝐵 𝑉 𝟏 − 𝐴 𝑉 𝝁 + 𝐶 𝑉 −1 𝝁 − 𝐴 𝑉 −1 𝟏 𝜇ℎ
−1 −1
𝐷 𝐷
𝓰 𝓱
• Result: Portfolio weights are linear in expected portfolio

return 𝒘ℎ = 𝓰 + 𝓱𝜇ℎ
– If 𝜇ℎ = 0, 𝒘ℎ = 𝓰
– If 𝜇ℎ = 1, 𝒘ℎ = 𝓰 + 𝓱
• Hence, 𝓰 and 𝓰 + 𝓱 are portfolios on the frontier
skip
Characterization of Frontier Portfolios

• Proposition: The entire set of frontier portfolios can
be generated by ("are convex combinations" 𝓰 of)
and 𝓰 + 𝓱.
• Proposition: The portfolio frontier can be described

as convex combinations of any two frontier
portfolios, not just the frontier portfolios 𝓰 and 𝓰 +
𝓱.
• Proposition: Any convex combination of frontier

portfolios is also a frontier portfolio. skip
…Characterization of Frontier Portfolios…
• For any portfolio on the frontier,

𝜎 2 𝜇ℎ = 𝓰 + 𝓱𝜇ℎ ′𝑉 𝓰 + 𝓱𝜇ℎ
with 𝓰 and 𝓱 as defined earlier.
Multiplying all this out and some algebra yields:
2
ℎ 𝐶 ℎ 𝐴 1
𝜎2 𝜇 = 𝜇 − +
𝐷 𝐶 𝐶
skip
…Characterization of Frontier Portfolios…

𝐴
i. the expected return of the minimum variance portfolio is ;
𝐶
1
ii. the variance of the minimum variance portfolio is given by ;
𝐶
𝐶 𝐴 2 1
iii. Equation 𝜎2 𝜇ℎ = 𝜇ℎ − + is a
𝐷 𝐶 𝐶
1 𝐴
– parabola with vertex ,
𝐶 𝐶
in the expected return/variance space
– hyperbola in the expected return/standard deviation space.
skip
𝐴 𝐷 2 1
𝐸 𝑟ℎ = ± 𝜎 −
𝐶 𝐶 𝐶
Figure 6-3 The Set of Frontier Portfolios: Mean/Variance Space

Figure 6-4 The Set of Frontier Portfolios: Mean/SD Space

Figure 6-5 The Set of Frontier Portfolios: Short Selling Allowed

Efficient Frontier with risk-free asset
The Efficient Frontier: One Risk Free and n Risky Assets


1
• min 𝒘′𝑉𝒘
𝒘 2
– s.t. 𝒘′𝝁 + 1 − 𝑤 𝑇 𝟏 𝑟 𝑓 = 𝜇ℎ
– FOC
• 𝒘ℎ = 𝜆𝑉 −1 𝝁 − 𝑟 𝑓 𝟏
𝑓 𝑇 𝜇 ℎ −𝑟 𝑓
• Multiplying by 𝝁 − 𝑟 𝟏 yields 𝜆 = ′
𝝁−𝑟 𝑓 𝟏 𝑉 −1 𝝁−𝑟 𝑓 𝟏
– Solution
𝑉 −1 𝝁−𝑟 𝑓 𝟏 𝜇 ℎ −𝑟 𝑓
• 𝒘ℎ = , where 𝐻 = 𝐵 − 2𝐴𝑟 𝑓 + 𝐶(𝑟 𝑓 )2
𝐻2
Efficient frontier with risk-free asset

• Result 1: Excess return in frontier excess return
𝑓
𝐸 𝑟𝑝 − 𝑟
cov 𝑟ℎ , 𝑟𝑝 = 𝒘′ℎ 𝑉𝒘𝑝 = 𝒘′ℎ 𝝁 − 𝑟 𝑓 𝟏
𝐻2
𝐸 𝑟ℎ − 𝑟 𝑓 𝐸 𝑟𝑝 − 𝑟 𝑓
=
𝐻2
𝑓 2
𝐸 𝑟𝑝 − 𝑟
var 𝑟𝑝 =
𝐻2
𝑓
cov 𝑟ℎ , 𝑟𝑝
𝐸 𝑟ℎ − 𝑟 = 𝐸 𝑟𝑝 − 𝑟 𝑓
var 𝑟𝑝
𝛽ℎ,𝑝
(Holds for any frontier portfolio 𝑝, in particular the market portfolio)


• Result 2: Frontier is linear in 𝐸 𝑟 , 𝜎 -space
2
𝐸 𝑟ℎ − 𝑟𝑓
var 𝑟ℎ =
𝐻2
𝐸 𝑟ℎ = 𝑟𝑓 + 𝐻𝜎ℎ
where 𝐻 is the Sharpe ratio

𝐸 𝑟ℎ − 𝑟𝑓
𝐻=
𝜎ℎ
Overview
1. Introduction:
– Projections
4. Testing CAPM
Aggregation: Two Fund Separation

• Doing it in two steps:
– First solve frontier for n risky asset
– Then solve tangency point
• Advantage:
– Same portfolio of n risky asset for different agents
with different risk aversion
– Useful for applying equilibrium argument (later)
Recall HARA class of preferences

Two Fund Separation
Price of Risk =
= highest
Sharpe ratio
Optimal Portfolios of Two Investors with Different Risk Aversion

Mean-Variance Preferences
𝜕𝑈 𝜕𝑈
• 𝑈 𝜇ℎ , 𝜎ℎ with > 0, 2 <0
𝜕𝜇ℎ 𝜕𝜎ℎ
𝜌
– Example: 𝐸 𝑊 − var 𝑊
2
• Also in expected utility framework

– Example 1: Quadratic utility function (with portfolio return 𝑅)
• 𝑈 𝑅 = 𝑎 + 𝑏𝑅 + 𝑐𝑅2
• vNM: 𝐸 𝑈 𝑅 = 𝑎 + 𝑏𝐸 𝑅 + 𝑐𝐸 𝑅2 = 𝑎 + 𝑏𝜇ℎ + 𝑐𝜇ℎ2 + 𝑐𝜎ℎ2 =
𝑔 𝜇ℎ , 𝜎ℎ
– Example 2: CARA Gaussian
• asset returns jointly normal ⇒ 𝑖 𝑤 𝑖 𝑟 𝑖 normal
𝜌
• If 𝑈 is CARA ⇒ certainty equivalent is 𝜇ℎ − 𝜎ℎ2
2
Overview
1. Introduction:
– Projections
4. Testing CAPM
Equilibrium leads to CAPM

• Portfolio theory: only analysis of demand
– price/returns are taken as given
– composition of risky portfolio is same for all investors
• Equilibrium Demand = Supply (market portfolio)
• CAPM allows to derive

– equilibrium prices/ returns.
– risk-premium
The CAPM with a risk-free bond

• The market portfolio is efficient since it is on the
efficient frontier.
• All individual optimal portfolios are located on the
half-line originating at point (0, 𝑟𝑓).
𝐸 𝑅 𝑚𝑘𝑡 −𝑅𝑓
• The slope of Capital Market Line (CML):
𝜎𝑚𝑘𝑡
𝐸 𝑅𝑚𝑘𝑡 − 𝑅𝑓
𝐸 𝑅ℎ = 𝑅𝑓 + 𝜎ℎ
𝜎𝑚𝑘𝑡
The Capital Market Line
CML
M
rM
rf
j
sM sp
The Security Market Line

E(r)
SML
E(ri)
E(rM)
rf
slope SML = (E(ri)-rf) /b i
b M= 1 bi b
Overview
1. Introduction:
prices/returns
– Aggregation: Fund Separation Theorem
– Projections
4. Practical Issues
Projections
• States 𝑠 = 1, … , 𝑆 with 𝜋𝑠 > 0
• Probability inner product
𝑥, 𝑦 𝜋 = 𝜋𝑠 𝑥𝑠 𝑦𝑠 = 𝜋𝑠 𝑥𝑠 𝜋𝑠 𝑦𝑠
𝑠 𝑠
• 𝜋-norm 𝑥 = 𝑥, 𝑥 𝜋 (measure of length)
i. 𝑥 > 0 ∀𝑥 ≠ 0 and 𝑥 = 0 if 𝑥 = 0
ii. 𝜆𝑥 = 𝜆 𝑥
iii. 𝑥 + 𝑦 ≤ 𝑥 + 𝑦 ∀𝑥; 𝑦 ∈ ℝ𝑆
)
shrink
axes
y y
x x
x and y are 𝜋-orthogonal iff 𝑥, 𝑦 𝜋 = 0, i.e. 𝐸 𝑥𝑦 = 0

…Projections…
• 𝒵 space of all linear combinations of vectors 𝑧1 , … , 𝑧𝑛
• Given a vector 𝑦 ∈ ℝ𝑆 solve
2
min𝑛 𝐸 𝑦 − 𝛼 𝑗 𝑧𝑗
𝛼∈ℝ
𝑗
𝑗 𝑗 𝑗
• FOC: 𝑠 𝜋𝑠 𝑦𝑠 − 𝑗 𝛼 𝑧𝑠 𝑧 = 0
– Solution 𝛼 ⇒ 𝑦 𝒵 = 𝑗 𝛼 𝑗 𝑧 𝑗 , 𝜖 ≔ 𝑦 − 𝑦 𝒵
• [smallest distance between vector y and Z space]

…Projections
y
e
yZ
𝐸 𝜀𝑧 𝑗 = 0 for each 𝑗 = 1, … , 𝑛 (FOC)

𝜀⊥𝑧
𝑦 𝑧 is the (orthogonal) projection on 𝒵
𝑦 = 𝑦 𝒵 + 𝜀 ′ , 𝑦 𝒵 ∈ 𝒵, 𝜀 ⊥ 𝑧
Expected Value and Co-Variance…

squeeze axis by 𝜋𝑠
(1,1)
𝑥, 𝑦 = 𝐸 𝑥𝑦 = cov 𝑥, 𝑦 + 𝐸 𝑥 𝐸 𝑦
x
𝑥, 𝑥 = 𝐸 𝑥 2 = var 𝑥 + 𝐸 𝑥 2
𝑥 𝑥 = 𝐸 𝑥2
𝑥 =𝑥+𝑥
…Expected Value and Co-Variance

• 𝑥 = 𝑥 + 𝑥 where
– 𝑥 is a projection of 𝑥 onto 1
⊥
– 𝑥 is a projection of 𝑥 onto 1
• 𝐸 𝑥 = 𝑥, 1 𝜋 = 𝑥, 1 𝜋 = 𝑥 1,1 𝜋 = 𝑥
scalar
• var 𝑥 = 𝑥, 𝑥 𝜋 = var[𝑥] slight abuse of notation
– 𝜎𝑥 = 𝑥 𝜋
• cov 𝑥, 𝑦 = cov 𝑥, 𝑦 = 𝑥, 𝑦 𝜋
• Proof: 𝑥, 𝑦 𝜋 = 𝑥, 𝑦 𝜋 + 𝑥, 𝑦 𝜋
– 𝑦, 𝑥 𝜋 = 𝑦, 𝑥 𝜋 = 0, 𝑥, 𝑦 𝜋 = 𝐸 𝑦 𝐸 𝑥 + cov[𝑥, 𝑦]
Overview
1. Introduction:
– Projections
4. Testing CAPM
Pricing Kernel ∗
𝑚 …
• 𝑋 space of feasible payoffs.
• If no arbitrage and 𝜋 ≫ 0 there exists
SDF 𝑚 ∈ ℝ𝑆 , 𝑚 ≫ 0, such that 𝑞 𝑧 = 𝐸 𝑚𝑧 .
• 𝑚 ∈ ℝ𝑆 – SDF need not be in asset span.
• A pricing kernel is a 𝑚∗ ∈ 𝑋 such that for
each 𝑧 ∈ 𝑋 , 𝑞 𝑧 = 𝐸 𝑚∗ 𝑧
…Pricing Kernel - Examples…

• Example 1:
1
–𝑆= 3, 𝜋 𝑠 =
3
1 2
– 𝑥1 = 1,0,0 , 𝑥2 = 0,1,1 and 𝑝 = ,
3 3
– Then 𝑚∗ = 1,1,1 is the unique pricing kernel.
• Example 2:
1 2
– 𝑥1 = 1,0,0 , 𝑥2 = 0,1,0 , 𝑝 = ,
3 3
– Then 𝑚∗ = 1,2,0 is the unique pricing kernel.
…Pricing Kernel – Uniqueness

• If a state price density exists, there exists a
unique pricing kernel.
– If dim 𝑋 = 𝑆 (markets are complete),
there are exactly 𝑚 equations and 𝑚 unknowns
– If dim 𝑋 < 𝑆, (markets may be incomplete)
For any state price density (=SDF) 𝑚 and any 𝑧 ∈ 𝑋
𝐸 𝑚 − 𝑚∗ 𝑧 = 0
𝑚 = 𝑚 − 𝑚∗ + 𝑚∗ ⇒ 𝑚∗ is the “projection” of 𝑚
on 𝑋
• Complete markets ⇒ 𝑚∗ = 𝑚 (SDF=state price density)
Expectations Kernel 𝑘 ∗
• An expectations kernel is a vector 𝑘 ∗ ∈ 𝑋

– Such that 𝐸 𝑧 = 𝐸 𝑘 ∗ 𝑧 for each 𝑧 ∈ 𝑋
• Example
1
– 𝑆 = 3, 𝜋 𝑠 = , 𝑥1 = 1,0,0 , 𝑥2 = 0,1,0
3
– Then the unique 𝑘 ∗ = 1,1,0
• If 𝜋 ≫ 0, there exists a unique expectations kernel.
• Let 𝐼 = 1, … , 1 then for any 𝑧 ∈ 𝑋
𝐸 𝐼 − 𝑘∗ 𝑧 = 0
– 𝑘 ∗ is the “projection” of 𝐼 on 𝑋
– 𝑘 ∗ = 𝐼 if bond can be replicated (e.g. if markets are complete)
Mean Variance Frontier

• Definition 1: 𝑧 ∈ 𝑋 is in the mean variance frontier if
there exists no 𝑧 ′ ∈ 𝑋 such that 𝐸 𝑧 ′ = 𝐸 𝑧 , 𝑞 𝑧 ′ =
𝑞 𝑧 and var 𝑧 ′ < var 𝑧
• Definition 2: Let ℰ be the space generated by 𝑚∗ and 𝑘 ∗

– Decompose 𝑧 = 𝑧 𝜀 + 𝜀 with 𝑧 ℰ ∈ ℰ and 𝜀 ⊥ ℰ
– Hence, 𝐸 𝜀 = 𝐸 𝜀𝑘 ∗ = 0, 𝑞 𝜀 = 𝐸 𝜀𝑚∗ = 0
cov 𝜀, 𝑧 𝜀 = 𝐸 𝜀𝑧 𝜀 = 0, since 𝜀 ⊥ ℰ
– var 𝑧 = var 𝑧 𝜀 + var 𝜀 (price of 𝜀 is zero, but positive variance)
• 𝑧 is in mean variance frontier ) z 2 E.

– Every 𝑧 ∈ ℰ is in mean variance frontier.
Frontier Returns…
• Frontier returns are the returns of frontier payoffs with non-zero
prices.
[Note: R indicates Gross return]
𝑘∗ 𝑘∗
𝑅𝑘 ∗ = =
𝑞∗ 𝑘 ∗ 𝐸𝑚 ∗
𝑚 𝑚∗
𝑅𝑚 ∗ = =
𝑞 𝑚∗ 𝐸 𝑚∗ 𝑚∗
• If 𝑧 = 𝛼𝑚∗ + 𝛽𝑘 ∗ then ∗
𝛼𝑞 𝑚 𝛽𝑞 𝑘 ∗
𝑅𝑧 = ∗ ∗ 𝑅𝑚 ∗ + ∗ ∗ 𝑅𝑘 ∗
𝛼𝑞 𝑚 + 𝛽𝑞 𝑘 𝛼𝑞 𝑚 + 𝛽𝑞 𝑘
𝜆 1−𝜆
• graphically: payoffs with price of p=1.

𝑋 = RS = R3
Mean-Variance Payoff Frontier

e
𝑚∗
Mean-Variance Return Frontier

p=1-line = return-line (orthogonal to 𝑚∗ )
Mean-Variance (Payoff) Frontier
(1,1,1) standard deviation
0 expected return
𝑚∗
NB: graphical illustrated of expected returns and standard deviation

changes if bond is not in payoff span.
Mean-Variance (Payoff) Frontier
efficient (return) frontier
(1,1,1) standard deviation
0 expected return
𝑚∗
inefficient (return) frontier

…Frontier Returns
(if agent is risk-neutral)
• If 𝑘 ∗ = 𝛼𝑚∗ , frontier returns ≡ 𝑅𝑘 ∗
• If𝑘 ∗ ≠ 𝛼𝑚∗ , frontier returns can be written as:
𝑅𝜆 = 𝑅𝑘 ∗ + 𝜆 𝑅𝑚∗ − 𝑅𝑘 ∗
• Expectations and variance are
𝐸 𝑅𝜆 = 𝐸 𝑅𝑘 ∗ + 𝜆 𝐸 𝑅𝑚∗ − 𝐸 𝑅𝑘∗
var 𝑅𝜆 =
= var 𝑅𝑘 ∗ + 2𝜆cov 𝑅𝑘 ∗ , 𝑅𝑚∗ − 𝑅𝑘 ∗ + 𝜆2 var 𝑅𝑚∗ − 𝑅𝑘 ∗
• If risk-free asset exists, these simplify to:
𝐸 𝑅𝑚∗ − 𝑅𝑓
𝐸 𝑅𝜆 = 𝑅𝑓 + 𝜆 𝐸 𝑅𝑚∗ − 𝑅𝑓 = 𝑅𝑓 ± 𝜎 𝑅𝜆
𝜎 𝑅𝑚∗
var 𝑅𝜆 = 𝜆2 var[𝑅𝑚∗ ] , 𝜎 𝑅𝜆 = 𝜆 𝜎 𝑅𝑚∗
Minimum Variance Portfolio

• Take FOC w.r.t. 𝜆 of
var 𝑅𝜆
= var 𝑅𝑘 ∗ + 2𝜆cov 𝑅𝑘 ∗ , 𝑅𝑚∗ − 𝑅𝑘 ∗
+ 𝜆2 var 𝑅𝑚∗ − 𝑅𝑘 ∗
• Hence, MVP has return of

𝑅𝑘 ∗ + 𝜆0 𝑅𝑚∗ − 𝑅𝑘 ∗
cov 𝑅𝑘 ∗ , 𝑅𝑚∗ − 𝑅𝑘 ∗
𝜆0 = −
var 𝑅𝑚∗ − 𝑅𝑘 ∗
Illustration of MVP
𝑋 = ℝ2 and 𝑆 = 3
Expected return
of MVP
Minimum standard
deviation
(1,1,1)
Mean-Variance Efficient Returns

• Definition: A return is mean-variance efficient if
there is no other return with same variance but
greater expectation.
• Mean variance efficient returns are frontier returns
with 𝐸 𝑅𝜆 ≥ 𝐸 𝑅𝜆0
• If risk-free asset can be replicated

– Mean variance efficient returns correspond to 𝜆0 .
– Pricing kernel (portfolio)
∗
is not mean-variance efficient,
since 𝐸 𝑅𝑚∗ = 𝐸𝐸 𝑚𝑚∗ 2 < 𝐸 𝑚1 ∗ = 𝑅𝑓
Zero-Covariance Frontier Returns

• Take two frontier portfolios with returns
𝑅𝜆 = 𝑅𝑘 ∗ + 𝜆 𝑅𝑚∗ − 𝑅𝑘 ∗ and 𝑅𝜇 = 𝑅𝑘 ∗ + 𝜇 𝑅𝑚∗ − 𝑅𝑘 ∗
• cov 𝑅𝜇 , 𝑅𝜆 = var 𝑅𝑘 ∗ + 𝜆 + 𝜇 cov 𝑅𝑘 ∗ , 𝑅𝑚∗ − 𝑅𝑘 ∗ +
𝜆𝜇var 𝑅𝑚∗ − 𝑅𝑘 ∗
• The portfolios have zero co-variance if

var 𝑅𝑘 ∗ + 𝜆cov 𝑅𝑘 ∗ , 𝑅𝑚∗ − 𝑅𝑘 ∗
𝜇=−
cov 𝑅𝑘 ∗ , 𝑅𝑚∗ − 𝑅𝑘 ∗ + 𝜆var 𝑅𝑚∗ − 𝑅𝑘 ∗
• For all 𝜆 ≠ 𝜆0 , 𝜇 exists

– 𝜇 = 0 if risk-free bond can be replicated
Illustration of ZC Portfolio…
𝑋 = ℝ2 and 𝑆 = 3
arbitrary portfolio p
(1,1,1)
Recall:
cov 𝑥, 𝑦 = 𝑥, 𝑦 𝜋
…Illustration of ZC Portfolio
Green lines do not
necessarily cross.
arbitrary portfolio p
(1,1,1)
ZC of p
Beta Pricing…
• Frontier Returns (are on linear subspace). Hence
𝑅𝛽 = 𝑅𝜇 + 𝛽 𝑅𝜆 − 𝑅𝜇
• Consider any asset with payoff 𝑥𝑗
– It can be decomposed in 𝑥𝑗 = 𝑥𝑗𝜀 + 𝜀𝑖
– 𝑞 𝑥𝑗 = 𝑞 𝑥𝑗𝜀 and 𝐸 𝑥𝑗 = 𝐸 𝑥𝑗𝜀 , since 𝜀 ⊥ ℰ
𝜀𝑗
– Return of 𝑥𝑗 is 𝑅𝑗 = 𝑅𝑗𝜀 +
𝑞 𝑥𝑗
– Using above and assuming 𝜆 ≠ 𝜆0 and 𝜇 is
ZC-portfolio of 𝜆,
𝜀𝑗
𝑅𝑗 = 𝑅𝜇 + 𝛽𝑗 𝑅𝜆 − 𝑅𝜇 +
𝑞 𝑥𝑗
…Beta Pricing
• Taking expectations and deriving covariance
• 𝐸 𝑅𝑗 = 𝐸 𝑅𝜇 + 𝛽𝑗 𝐸 𝑅𝜆 − 𝐸 𝑅𝜇
cov 𝑅𝜆 ,𝑅𝑗
• cov 𝑅𝜆 , 𝑅𝑗 = 𝛽𝑗 var 𝑅𝜆 ⇒ 𝛽𝑗 =
var 𝑅𝜆
𝜀𝑗
– Since 𝑅𝜆 ⊥
𝑞 𝑥𝑗
• If risk-free asset can be replicated, beta-pricing
equation simplifies to
𝐸 𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 𝐸 𝑅𝜆 − 𝑅𝑓
• Problem: How to identify frontier returns

Capital Asset Pricing Model…

• CAPM = market return is frontier return
– Derive conditions under which market return is frontier return
– Two periods: 0,1.
– Endowment: individual 𝑤1𝑖 at time 1, aggregate 𝑤1 = 𝑤1𝑋 +
𝑤1𝑌 , where 𝑤1𝑋 , 𝑤1𝑌 are orthogonal and 𝑤1𝑋 is the
orthogonal projection of 𝑤1 on 𝑋 .
– The market payoff is 𝑤1𝑋
𝑋
𝑤1
– Assume 𝑞 𝑤1𝑋 ≠ 0, let 𝑅𝑚𝑘𝑡 = 𝑋 , and assume that
𝑞 𝑤1
𝑅𝑚𝑘𝑡 is not the minimum variance return.
…Capital Asset Pricing Model

• If 𝑅0 is the frontier return that has zero
covariance with 𝑅𝑚𝑘𝑡 then, for every security j,
• 𝐸 𝑅𝑗 = 𝐸 𝑅0 + 𝛽𝑗 𝐸 𝑅𝑚𝑘𝑡 − 𝐸 𝑅0 with
cov 𝑅𝑗 ,𝑅𝑚𝑘𝑡
𝛽𝑗 =
var 𝑅𝑚𝑘𝑡
• If a risk free asset exists, equation becomes,

𝐸[𝑅𝑗 ] = 𝑅𝑓 + 𝛽𝑗 𝐸 𝑅𝑚𝑘𝑡 − 𝑅𝑓
• N.B. first equation always hold if there are only two assets.
Overview
1. Introduction:
– Projections
4. Testing CAPM
Practical Issues
• Testing of CAPM
• Jumping weights
– Domestic investments
– International investment
• Black-Litterman solution
Testing the CAPM

• Take CAPM as given and test empirical implications
• Time series approach

– Regress individual returns on market returns
𝑅𝑖𝑡 − 𝑅𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 − 𝑅𝑓𝑡 + 𝜀𝑖𝑡
– Test whether constant term 𝛼𝑖 = 0
• Cross sectional approach

– Estimate betas from time series regression
– Regress individual returns on betas
𝑅𝑖 = 𝜆𝛽𝑖𝑚 + 𝛼𝑖
– Test whether regression residuals 𝛼𝑖 = 0
Empirical Evidence
• Excess returns on high-beta stocks are low
• Excess returns are high for small stocks
– Effect has been weak since early 1980s
• Value stocks have high returns despite low
betas
• Momentum stocks have high returns and low
betas
Reactions and Critiques

• Roll Critique
– The CAPM is not testable because composition of true
market portfolio is not observable
• Hansen-Richard Critique
– The CAPM could hold conditionally at each point in
time, but fail unconditionally
• Anomalies are result of “data mining”
• Anomalies are concentrated in small, illiquid
stocks
• Markets are inefficient – “joint hypothesis test”
Practical Issues
• Estimation
– How do we estimate all the parameters we need for
portfolio optimization?
• What is the market portfolio?

– Restricted short-sales and other restrictions
– International assets & currency risk
• How does the market portfolio change over time?

– Empirical evidence
– More in dynamic models
Overview
1. Introduction:
– Projections
4. Testing CAPM
5. Practical Issues – Black Litterman
MV Portfolio Selection in Real Life

• An investor seeking to use mean-variance
portfolio construction has to
– Estimate N means,
– N variances,
– N*(N-1)/2 co-variances
• Estimating means
– For any partition of [0,T] with N points (∆t=T/N):
1 1 𝑁 𝑝𝑇 −𝑝0
𝐸𝑟 = ⋅ ⋅ 𝑖=1 𝑟𝑖⋅Δ𝑡 = (in log prices)
Δ𝑡 𝑁 𝑇
– Knowing the first and last price is sufficient
Estimating Means
• Let 𝑋𝑘 denote the logarithmic return on the market, with 𝑘 =
1, … , 𝑛 over a period of length ℎ
– The dynamics to be estimated are:
𝑋𝑘 = 𝜇 ⋅ Δ + 𝜎 ⋅ Δ ⋅ 𝜖𝑘
where the 𝜖𝑘 are i.i.d. standard normal random variables.
– The standard estimator for the expected logarithmic mean rate of
return is:
1 𝑛 where
𝜇= ⋅ 𝑋𝑘 ℎ is length of observation
ℎ 1
𝑛 number of observations
– The mean and variance of this estimator Δ = 𝑛/ℎ
1 𝑛 1
𝐸 𝜇 = ⋅𝐸 𝑋𝑘 = ⋅𝑛⋅𝜇⋅Δ=𝜇
ℎ 1 ℎ
1 𝑛 1 2
𝜎2
𝑉𝑎𝑟 𝜇 = 2 ⋅ 𝑉𝑎𝑟 𝑋𝑘 = 2⋅𝑛⋅𝜎 ⋅Δ=
ℎ 1 ℎ ℎ
– The accuracy of the estimator depends only upon the total length of the observation period (h), and not upon the number of
observations (n).
Estimating Variances
• Consider the following estimator:
1 𝑛 2
𝜎2 = ⋅ 𝑖=1 𝑋𝑘
ℎ
• The mean and variance of this estimator:

𝑛
1 1 ℎ
𝐸 𝜎2 = ⋅ 𝐸 𝑋𝑘2 = ⋅ 𝑛 ⋅ 𝜇2 ⋅ Δ2 + 𝜎 2 ⋅ Δ = 𝜎 2 + 𝜇2 ⋅
ℎ ℎ 𝑛
𝑖=1
𝑛 𝑛
1 1 𝑛 2 2 ⋅ 𝜎 4 4 ⋅ 𝜇2 ⋅ ℎ
𝑉𝑎𝑟 𝜎2 = 2 ⋅ 𝑉𝑎𝑟 𝑋𝑘2 = 2⋅ 𝑉𝑎𝑟 𝑋𝑘2 = 2 ⋅ 𝐸 𝑋𝑘4 − 𝐸 𝑋𝑘2 = +
ℎ ℎ ℎ 𝑛 𝑛2
𝑖=1 𝑖=1
– The estimator is biased b/c we did not subtract out the

expected return from each realization.
– Magnitude of the bias declines as n increases.
– For a fixed h, the accuracy of the variance estimator can be
improved by sampling the data more frequently.
Estimating variances:
Theory vs. Practice
• For any partition of [0, 𝑇] with 𝑁 points (Δ𝑡 = 𝑇/𝑁):
𝑁
1 2
𝑉𝑎𝑟 𝑟 = ⋅ 𝑟𝑖⋅Δ𝑡 − 𝐸 𝑟 → 𝜎 2 𝑎𝑠 𝑁 → ∞
𝑁
𝑖=1
• Theory: Observing the same time series at

progressively higher frequencies increases the
precision of the estimate.
• Practice:
– Over shorter interval increments are non-Gaussian
– Volatility is time-varying (GARCH, SV-models)
– Market microstructure noise
Estimating covariances:
Theory vs. Practice
• In theory, the estimation of covariances shares
the features of variance estimation.
• In practice:
– Difficult to obtain synchronously observed time-series -> may require
interpolation, which affects the covariance estimates.
– The number of covariances to be estimated grows very quickly, such
that the resulting covariance matrices are unstable (check condition
numbers!).
– Shrinkage estimators (Ledoit and Wolf, 2003, “Honey, I Shrunk the
Covariance Matrix”)
Unstable Portfolio Weights

• Are optimal weights statistically different from zero?
– Properly designed regression yields portfolio weights
– Statistical tests for significance of weight
• Example: Britton-Jones (1999) for international portfolio

– Fully hedged USD Returns
• Period: 1977-1966
• 11 countries
– Results
• Weights vary significantly across time and in the cross section
• Standard errors on coefficients tend to be large
Britton-Jones (1999)
1977-1996 1977-1986 1987-1996
weights t-stats weights t-stats weights t-stats
Australia 12.8 0.54 6.8 0.20 21.6 0.66
Austria 3.0 0.12 -9.7 -0.22 22.5 0.74
Belgium 29.0 0.83 7.1 0.15 66 1.21
Canada -45.2 -1.16 -32.7 -0.64 -68.9 -1.10
Denmark 14.2 0.47 -29.6 -0.65 68.8 1.78
France 1.2 0.04 -0.7 -0.02 -22.8 -0.48
Germany -18.2 -0.51 9.4 0.19 -58.6 -1.13
Italy 5.9 0.29 22.2 0.79 -15.3 -0.52
Japan 5.6 0.24 57.7 1.43 -24.5 -0.87
UK 32.5 1.01 42.5 0.99 3.5 0.07
US 59.3 1.26 27.0 0.41 107.9 1.53
Black-Litterman Appraoch
• Since portfolio weights are very unstable, we need to discipline our
estimates somehow
– Our current approach focuses only on historical data
• Priors
– Unusually high (or low) past return may not (on average) earn the same
high (or low) return going forward
– Highly correlated sectors should have similar expected returns
– A “good deal” in the past (i.e. a good realized return relative to risk)
should not persist if everyone is applying mean-variance optimization.
• Black Litterman Approach

– Begin with “CAPM prior”
– Add views on assets or portfolios
– Update estimates using Bayes rule
Black-Litterman Model: Priors

• Suppose the returns of 𝑁 risky assets (in vector/matrix notation) are
𝑟 ∼ 𝒩(𝜇, Σ)
• CAPM: The equilibrium risk premium on each asset is given by:

Π = 𝛾 ⋅ Σ ⋅ 𝑤𝑒𝑞
– 𝛾 is the investors coefficient of risk aversion.
– 𝑤𝑒𝑞 are the equilibrium (i.e. market) portfolio weights.
• The investor is assumed to start with the following Bayesian prior (with
imprecision):
𝜇 = Π + 𝜖 𝑒𝑞 where 𝜖 𝑒𝑞 ∼ 𝑁 0, 𝜏 ⋅ Σ
– The precision of the equilibrium return estimates is assumed to be
proportional to the variance of the returns.
– 𝜏 is a scaling parameter
Black-Litterman Model: Views

• Investor views on a single asset affect many weights.
• “Portfolio views”
– Investor views regarding the performance of K portfolios
(e.g. each portfolio can contain only a single asset)
– P: K x N matrix with portfolio weights
– Q: K x 1 vector of views regarding the expected returns of
these portfolios
• Investor views are assumed to be imprecise:
𝑃 ⋅ 𝜇 = 𝑄 + 𝜖 𝑣 where 𝜖 𝑣 ∼ 𝑁(0, Ω)
– Without loss of generality, Ω is assumed to be a diagonal
matrix
– 𝜖 𝑒𝑞 and 𝜖 𝑣 are assumed to be independent
Black-Litterman Model: Posterior

• Bayes rule:
𝑓(𝜃, 𝑥) 𝑓 𝑥 𝜃 ⋅ 𝑓(𝜃)
𝑓 𝜃𝑥 = =
𝑓 𝑥 𝑓(𝑥)
• Posterior distribution:
– If 𝑋1 , 𝑋2 are normally distributed as:
𝑋1 𝜇1 Σ Σ12
∼ 𝑁 𝜇 , 11
𝑋2 2 Σ21 Σ22
– Then, the conditional distribution is given by
−1 −1
𝑋1 |𝑋2 = 𝑥 ∼ 𝑁 𝜇1 + Σ12 Σ22 𝑥 − 𝜇2 , Σ11 − Σ12 Σ22 Σ21
Black-Litterman Model: Posterior

• The Black-Litterman formula for the posterior
distribution of expected returns
𝐸𝑅𝑄
= 𝜏 ⋅ Σ −1 + 𝑃′ ⋅ Ω−1 ⋅ 𝑃 −1
⋅ 𝜏 ⋅ Σ −1 ⋅ Π + 𝑃′ ⋅ Ω−1 ⋅ 𝑄
−1
var 𝑅 𝑄 = 𝜏⋅Σ + 𝑃′ ⋅ Ω−1 ⋅ 𝑃 −1
Black Litterman: 2-asset Example

• Suppose you have a view on the equally
1 1
weighted portfolio 𝜇1 + 𝜇2 = 𝑞 + 𝜀 𝑣
2 2
• Then
−1
−1
1 −1
𝑞
𝐸𝑅𝑄 = 𝜏⋅Σ + ⋅ 𝜏⋅Σ ⋅Π+
2Ω 2Ω
−1
−1
1
var 𝑅 𝑄 = 𝜏⋅Σ +
2Ω
Advantages of Black-Litterman
• Returns are adjusted only partially toward the
investor’s views using Bayesian updating
– Recognizes that views may be due to estimation error
– Only highly precise/confident views are weighted heavily.
• Returns are modified in way that is consistent with
economic priors
– Highly correlated sectors have returns modified in the
same direction.
• Returns can be modified to reflect absolute or relative
views.
• Resulting weight are reasonable and do not load up on
estimation error.

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FIN501 Asset Pricing

Lecture 06 Mean-Variance & CAPM (1)

Recall State-price Beta model

very general – but what is 𝑅 ∗ in reality?

Simple CAPM with Quadratic Expected Utility

1. All agents are identical

Simple CAPM with Quadratic Expected Utility

2. Homogenous agents + Exchange economy

Definition: Mean-Variance Dominance

Expected Portfolio Returns & Variance

• Expected returns (linear)

Illustration of 2 Asset Case

• Special cases [𝑤1 to obtain certain 𝜎ℎ ]

𝜎1 𝜎ℎ 𝜎2 Lower part is irrelevant

The Efficient Frontier: Two Perfectly Correlated Risky Assets

The Efficient Frontier: Two Perfectly Negative Correlated Risky Assets

For 𝜌12 ∈ −1,1

The Efficient Frontier: Two Imperfectly Correlated Risky Assets

The Efficient Frontier: One Risky and One Risk-Free Asset

Efficient frontier with n risky assets

The first FOC can be written as:

• Noting that 𝝁′ 𝒘ℎ = 𝑤ℎ′ , combining 1st and 2nd FOC

• Pre-multiplying the 1st FOC by 1 yields

• Result: Portfolio weights are linear in expected portfolio

Characterization of Frontier Portfolios

• Proposition: The portfolio frontier can be described

• Proposition: Any convex combination of frontier

…Characterization of Frontier Portfolios…

• For any portfolio on the frontier,

Multiplying all this out and some algebra yields:

…Characterization of Frontier Portfolios…

Figure 6-3 The Set of Frontier Portfolios: Mean/Variance Space

Figure 6-4 The Set of Frontier Portfolios: Mean/SD Space

Figure 6-5 The Set of Frontier Portfolios: Short Selling Allowed

Efficient Frontier with risk-free asset

The Efficient Frontier: One Risk Free and n Risky Assets

Efficient Frontier with risk-free asset

Efficient frontier with risk-free asset

(Holds for any frontier portfolio 𝑝, in particular the market portfolio)

Efficient Frontier with risk-free asset

where 𝐻 is the Sharpe ratio

Aggregation: Two Fund Separation

Recall HARA class of preferences

Two Fund Separation

Optimal Portfolios of Two Investors with Different Risk Aversion

• Also in expected utility framework

Equilibrium leads to CAPM

• Equilibrium Demand = Supply (market portfolio)

• CAPM allows to derive

The CAPM with a risk-free bond

The Capital Market Line

The Security Market Line

x and y are 𝜋-orthogonal iff 𝑥, 𝑦 𝜋 = 0, i.e. 𝐸 𝑥𝑦 = 0

• [smallest distance between vector y and Z space]

𝐸 𝜀𝑧 𝑗 = 0 for each 𝑗 = 1, … , 𝑛 (FOC)

Expected Value and Co-Variance…

…Expected Value and Co-Variance

…Pricing Kernel - Examples…

…Pricing Kernel – Uniqueness

• An expectations kernel is a vector 𝑘 ∗ ∈ 𝑋

Mean Variance Frontier

• Definition 2: Let ℰ be the space generated by 𝑚∗ and 𝑘 ∗